What happens when property that a trustee wants to sell in a section 363 sale is subject to unexpired leases that the trustee is empowered to reject under section 365(h)? The Ninth Circuit faced this conundrum in a recent case involving a luxury real estate development in Montana, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 892 F.3d 892 (9th Cir. 2017). Wrestling with a split between its sister circuits, the Ninth Circuit ultimately concluded that, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict,” and the trustee could properly proceed with the sale.

Spanish Peaks, a 5,700-acre resort in Big Sky, Montana, was financed by a $130 million loan secured by a mortgage and assignment of rents from Citigroup Global Markets Realty Corp. Citigroup assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (“SPAP”).

At issue on appeal were two leases at the resort. The first was a restaurant space that Spanish Peaks Holdings, LLC (“SPH”) leased for $1,000 per month to Spanish Peaks Development, LLC (“SPD”). SPH and SPD later replaced the lease with a 99-year leasehold for $1,000 per year in rent. SPD assigned its interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”). The second was a parcel of commercial real estate SPH leased to Montana Opticom, LLC (“Opticom”), for a term of 60 years and annual rent of $1,285.

SPH defaulted on its loan payments and filed, along with two related entities, Chapter 7 petitions in Delaware. SPAP, SPH’s largest creditor with a claim of $122 million secured by the mortgage, assigned its claim to CH SP Acquisitions, LLC (“CH SP”). The trustee and SPAP agreed to a plan to liquidate “substantially” all of the debtors’ property through an auction with a minimum bid of $20 million. The trustee sought approval for sale of the property “free and clear of all liens,” except for certain enumerated encumbrances and liens to be paid out of the sale proceeds or otherwise protected.

The Pinnacle and Opticom leases were mentioned neither on the list of surviving encumbrances nor on the list of protected liens.. Both entities thus objected to any sale “free and clear of [their] leasehold interests.” 872 F.3d at 895. The bankruptcy court authorized the sale but did not rule on Pinnacle’s and Opticom’s objections. The court instead deferred them until the hearing on the motion to approve the sale.

At the auction and approval hearing on June 3, 2013, CH SP won the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their claim that their leases allowed them to retain possession and objected to the “free and clear” language in the proposed approval order.

The bankruptcy court approved the sale, holding that the sale was free and clear of any “Interests,” including any leases “except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure.” Id. at 896. After some procedural back-and-forth and another evidentiary hearing, the bankruptcy court found defects in Pinnacle’s and Opticom’s leases, and noted that they had neither requested adequate protection for their interests nor proven that they would suffer economic harm if their interests were terminated. The bankruptcy court thus held the sale was free and clear of the Pinnacle and Opticom leases, and the district court affirmed.

On appeal, the Ninth Circuit considered whether the leases survived the sale to CH SP, which gave rise to an apparent conflict between the trustee’s ability to sell property of the estate under section 363 and authority to assume or reject unexpired leases under section 365(a) and (h). Section 365 gives a lessee in possession with two choices: “treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.” Id. at 898.

Other circuits had taken one of two approaches to the apparent conflict. The majority held that section 365 outweighed section 363 “under the canon of statutory construction that ‘the specific prevails over the general.’” Id. (internal citation omitted).

In contrast, the Seventh Circuit had held that “the statutory provisions themselves do not suggest that one supersedes or limits the other.” Id. (quoting Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537, 547 (7th Cir. 2003)). In other words, section 363 confers a right to sell property free and clear of “any interest” without exempting leases protected under section 365, while section 365(h) focuses on the specific event of the rejection of an executory contract without reference to sales of estate property under section 363. The Seventh Circuit explained:

Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property. So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.

327 F.3d at 548.

The Ninth Circuit agreed with the Seventh Circuit’s approach as the best way to reconcile the two statutes, noting that while “[a] sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, . . . it is not the same thing as the ‘rejection’ contemplated by section 365.” 872 F.3d at 899.

Here, then, the trustee had not rejected the Pinnacle and Opticom leases, so section 365 was not in play, and section 363(f)(1) authorized the sale of the property free and clear of the leases. The Ninth Circuit therefore affirmed the judgment of the district court.

An increasingly common aspect of Chapter 11 plans is non-consensual third party releases, which are often a vital tool required to obtain global peace among competing constituencies whose support is often needed for a debtor to obtain confirmation of a Chapter 11 plan. However, the parameters of a bankruptcy court’s Constitutional authority to approve such non-consensual releases has, to date, been unclear. Clarity, however, has been provided by the recent decision by the United States Bankruptcy Court for the District of Delaware In re Millennium Lab Holdings II, LLC,[1] where the Court concluded that it had constitutional authority to confirm a restructuring plan that released third parties from liability to certain creditors, even though those creditors had not consented to the releases. The Bankruptcy Court’s ruling will be of interest to potential debtors and other potential releasees who may seek to employ or benefit from non-consensual third party releases as well as to lenders and other creditors who may find themselves bound by non-consensual release contained in a Chapter 11 plan.

Debtor Millennium Lab Holdings II, LLC and certain affiliates commenced their Chapter 11 Cases in 2015 following a settlement with the United States federal government and certain states relating to alleged violations of the Anti-Kickback Statute, the False Claims Act, and the Stark Act (which relates to physician referrals for Medicare and Medicaid services). In December 2015, the Bankruptcy Court confirmed a Plan of Reorganization which contained settlements with certain equity holders (the “Non-Debtor Equity Holders”), who contributed $325 million to the estate and received third party releases. Immediately prior to the confirmation hearing, certain dissenting creditors (the “Opt-Out Lenders”) commenced a lawsuit asserting common law fraud and RICO claims against the Non-Debtor Equity Holders. The Opt-Out Lenders also filed an objection to the non-consensual third party releases in the proposed Plan. The Opt-Out Lenders argued that the Plan’s non-consensual releases went beyond the scope of the Bankruptcy Court’s authority.[2]

The Bankruptcy Court overruled the Opt-Out Lenders’ arguments and confirmed the Plan in a bench ruling on December 11, 2015. Thereafter, in a January 12, 2016 written opinion, the Bankruptcy Court certified an appeal directly to the Third Circuit on the following question: “Do Bankruptcy Courts have the authority to release a non-debtor’s direct claims against other non-debtors for fraud and other willful misconduct without the consent of the releasing non-debtor?”[3] The Third Circuit denied the petition for permission to appeal, and the appeal was docketed with the Delaware District Court.[4]

In the District Court, the Opt-Out Lenders principally pursued an argument based on the Supreme Court’s decision in Stern v. Marshall.[5] According to the Opt-Out Lenders, the Bankruptcy Court lacked constitutional authority to enter a final order releasing direct, non-bankruptcy claims against non-debtors. The District Court remanded the case to the Bankruptcy Court to decide that issue. In doing so, however, the District Court provided its own view of the merits and voiced agreement with the Opt-Out Lenders’ Stern argument. The District Court stated that it was “persuaded by [the Opt-Out Lenders’] argument that the Plan’s release, which permanently extinguished [the Opt-Out Lenders’] claims, is tantamount to resolution of those claims on the merits” and that it believed that “[i]f Article III prevents the Bankruptcy Court from entering a final order disposing of a non-bankruptcy claim against a nondebtor outside of the proof of claim process, it follows that this prohibition should be applied regardless of the proceeding (i.e., adversary proceeding, contested matter, plan confirmation).”[6]

On remand, the Bankruptcy Court concluded that it did have the authority to grant the release of the Opt-Out Lenders’ claims via confirmation of the Plan. In its analysis, the Bankruptcy Court laid out a continuum of interpretations of Stern. On one end of the continuum, the narrow interpretation reads Stern only as prohibiting a bankruptcy court from entering a “final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.”[7] Next, a relatively broad interpretation of Stern would prohibit a bankruptcy court from entering a final judgment on “all state law claims, all common law causes of action or all causes of action under state law.”[8] Finally, the broadest view of Stern holds “that bankruptcy judges should examine their ability to enter final orders in all enumerated or unenumerated core proceedings.”[9]

The Bankruptcy Court held that it possessed constitutional authority to confirm the Plan under both the narrow and broad views of Stern because confirmation of a plan is neither a state law counterclaim nor a state law claim of any kind.[10] Furthermore, even under the broadest interpretation of Stern, the Bankruptcy Court maintained constitutional authority to confirm the plan because (1) confirmation is at the core of a bankruptcy judge’s power, (2) confirmation applies a “federal standard,” and (3) the confirmation of the Plan met the Third Circuit’s “standard of fairness and necessity to the reorganization.”[11]

The Bankruptcy Court also rejected the Opt-Out Lenders’ interpretation of Stern. The Opt-Out Lenders argued that confirmation would violate Stern’s statement that “the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” The Bankruptcy Court questioned whether that disjunctive test was the appropriate measure of the constitutionality of a restructuring plan, and further held that confirmation of the Plan was constitutional because the Plan stemmed from the Chapter 11 Cases and “the releases were integral to confirmation and thus integral to the restructuring of the debtor-creditor relationship.”[12]

The Bankruptcy Court also dismissed the Opt-Out Lenders’ functionalist argument that, because confirmation had the effect of extinguishing their RICO lawsuit, the confirmation constituted an “impermissible adjudication of the litigation being released.” Relying on pre-Stern Third Circuit precedent,[13] the Bankruptcy Court concluded that a confirmation order can permissibly impact and even extinguish lawsuits in non-core proceedings. The Bankruptcy Court went on to note that, if taken to its logical conclusion, the Opt-Out Lenders’ interpretation of Stern would apply to an eye-popping range of core bankruptcy matters, including substantive consolidation, recharacterization and subordination of debts, and practically every section 363 sale.

In short, the Bankruptcy Court held that, regardless of Stern, bankruptcy courts have constitutional authority to confirm restructuring plans that include non-consensual releases of claims against third parties. Furthermore, Stern does not extend to core proceedings concerning federal law that implicate state law rights.

Although Stern is now nearly eight years old, its meaning remains a source of controversy and litigation in bankruptcy courts. The range of possible interpretations of Stern described by the Bankruptcy Court—as well as the differing view offered by the District Court—show that courts have not yet settled how Stern affects even routine and fundamental bankruptcy court business. Perhaps not surprisingly in light of the long history of the dispute and the District Court’s decision, the Opt-Out Lenders have filed a notice of appeal of the Bankruptcy Court’s decision. Stay tuned to the HHR Bankruptcy Report to stay apprised of further developments.

[2]. According to the Bankruptcy Court, the Opt-Out Lenders raised four objections to the releases: (i) the court lacked subject matter jurisdiction to grant nonconsensual third party releases, (ii) the releases were impermissible, (iii) the Plan impermissibly did not allow parties to opt-out of the releases, and (iv) the releases were inconsistent with the Third Circuit’s holding in Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000).

On August 10, 2017, the Supreme Court dismissed the writ of certiorari in PEM Entities LLC v. Levin as improvidently granted. See No. 16-492, 2017 WL 3429146, at *1 (U.S. Aug. 10, 2017). This decision leaves the circuit courts split on the issue of whether to use federal or state law in recharacterizing insider debt as equity, a critical distinction that can be dispositive as to the treatment of debt claims made by insiders of debtors.

Case Background

In PEM Entities LLC, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from Paragon Commercial Bank (the “Loan”). The Debtor subsequently defaulted on the Loan, eventually resulting in foreclosure proceedings. The Debtor, its principal, and other related entities entered into a settlement agreement with the lender. Under the settlement, Paragon Commercial Bank sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for around $1.2 million. Critically, PEM was owned by insiders of the Debtor, relied solely upon principals of the Debtor to negotiate the settlement agreement, and failed to set out formal interest rates and payment schedules with the Debtor after the settlement of the loan. When the Debtor could not maintain liquidity despite PEM’s intervention, the Debtor filed this Chapter 11 case, wherein PEM filed a secured claim for $7 million. The Debtor’s unsecured debtholders moved to recharacterize the secured claim as equity.

Using the 11 factor federal test for recharacterizing insider debt claims laid out in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453 F.3d 225, 231 (4th Cir. 2006), the United States Bankruptcy Court for the Eastern District of North Carolina held that PEM’s claim would be recharacterized as equity rather than debt, moving the claim to lower priority status than the unsecured debtholders. Both the district and circuit courts affirmed on appeal, with the Fourth Circuit signaling that the federal, rather than state, test for recharacterization would be proper and that PEM’s actions, while arguably debt in name, was at its core a capital investment in the company’s success rather than the temporary borrowing of money.

The Unresolved Circuit Split

The Supreme Court’s decision to dismiss the writ of certiorari in PEM Entities LLC leaves in place a Circuit split on whether to use federal or state law standards to recharacterize debt. The Sixth, Tenth, Third, and Fourth Circuits all use a multi-factor test similar to the one used in PEM Entities, LLC that looks beyond form and to the substance of the transaction to decide whether it should be categorized as debt or equity.[1] Similarly, the Eleventh Circuit applies a two-prong federal standard that also attempts to reach the substance of the transaction.[2] On the other hand, the Fifth and Ninth Circuits have applied an approach to recharacterization based on the state law of the forum.[3] These state laws vary greatly from state to state, but they are often more friendly to debtor insiders who invest in debt and look to the form of the transaction rather than the substance.

Reason for Dismissal

The circumstances of the dismissal further dampen the hopes of a quick resolution to this circuit split. On October 11, 2016, PEM petitioned the Supreme Court for a writ of certiorari to review the Fourth Circuit decision on the issue of whether federal or state law should be applied to recharacterize debt as equity. On June 27, 2017, this writ was granted only to be dismissed as improvidently granted six weeks later, prior to merits briefing, on August 10, 2017. The Supreme Court is not obligated to explain its reasoning for dismissing certiorari and did not here. Usually, certiorari is dismissed as improvidently granted if a party attempts to change its argument in its merits brief, if the dispute seems overly fact determinative, or if the Justices believe that the case has secondary issues that may prevent the court from reaching the merits also known as “vehicle” problems.

Here, certiorari was dismissed shortly after the parties filed a joint motion to confirm party status on July 21, 2017. The original respondents for this action had settled a state court action which caused them to cease having a stake in the outcome of this case. Instead, the parties moved the court for the Debtor to step into the unsecured debtors shoes as the respondents in this action, as they had a continued interest in defending the judgment below. Given the short period of time between the filing of this motion and the dismissal of certiorari as improvidently granted, as well as the fact that merits briefing was never even completed, it is likely that the Court dismissed this case due to “vehicle” issues. That is, the Court decided that, due to the complexity of the party’s status and procedural posture, the likelihood that the Court would not reach the merits of the action had risen and it was no longer worth the risk of using its limited resources to hear the case. This issue may continue to hamper attempts to bring the issue of this circuit split to the Supreme Court, as the interconnected and complex nature of relationships between parties in cases dealing with recharacterizing insider debt as equity rarely make the best simple and clear-cut vehicles for Supreme Court rulings.

[2]. In re N & D Properties, Inc., 799 F.2d 726, 733 (11th Cir. 1986) (two-pronged test, shareholder loans may be deemed capital contributions “where the trustee proves initial undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”).

Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code. The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer.[1] The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.

Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor. The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers. Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities. It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”[2]

The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford Downs, a racino industry competitor. The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.

The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection: a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit.[3] On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers.[4] The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor.[5] Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.

Bankruptcy practitioners and scholars are watching this case with great interest. The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose.[6] Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents. These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place.[7] They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.[8]

The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems. The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending. The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners,[9] and the Tribune unsecured creditors submitted a brief in support of Respondent.[10]

We are pleased to share with you the Hughes Hubbard Bankruptcy Mid-Year Review for 2017. The review recaps a number of notable developments from this year. We thank our clients for their continued confidence and look forward to providing you with bankruptcy and restructuring guidance.

The United States Bankruptcy Court for the Southern District of New York recently held that it had personal jurisdiction over a foreign defendant that was paid funds pursuant to the Court’s order approving the debtors’ post-petition financing (the “DIP order”), denying defendant Immigon’s[1] motion to dismiss an adversary proceeding commenced by the Motors Liquidation Company Avoidance Action Trust seeking to clawback the funds.[2]

In 2006, General Motors entered into a $1.5 billion Term Loan Agreement under which JP Morgan Chase Bank, N.A. and several other large financial institutions committed to provide funding and had the right to sell interests in the loan in the secondary market. In 2008, in connection with terminating a completely separate transaction, JP Morgan mistakenly authorized the termination of the security interest in the General Motors’ assets securing the loan.

Under the debtors’ DIP order, the Court authorized the debtors’ to pay in full all of General Motors’ obligations under the Term Loan Agreement, subject to the Official Committee of Unsecured Creditors’ right to investigate and challenge the perfection of the liens securing the loan. Following entry of the order, GM paid approximately $1.4 billion to its lenders under the Term Loan Agreement, including approximately $9.8 million to defendant Immigon on account of its $10 million interest in the loan purchased on the secondary market from JP Morgan.

In denying Immigon’s motion to dismiss, including on the grounds that the Court lacked personal jurisdiction over Immigon, the Court found that under the Term Loan Agreement, Immigon had expressly consented to personal jurisdiction in New York and waived the right to object to any New York State or Federal Court as the forum for any disputes arising out of the Agreement. Moreover, the Court found that the consent to jurisdiction and forum selections clauses should be enforced because Immigon “enjoyed the benefits and protection of New York law” in connection with the Agreement.

As a separate basis for exercising jurisdiction, the Court also held that Immigon consented to jurisdiction under the DIP order, which provided that any party receiving funds under the order consented to the jurisdiction of the Bankruptcy Court. Relying on evidence showing that an employee of Immigon had actually received and viewed the DIP order before receiving payment, the Court found that Immigon had knowingly consented to the jurisdiction provision in the DIP order by accepting payment of the funds.

As a third distinct basis for exercising jurisdiction over Immigon, the Court held that even if Immigon had not consented to the Court’s jurisdiction, sufficient minimum contacts existed between the litigation, New York and Immigon for the Court to exercise specific personal jurisdiction over Immigon. Specifically, the Court noted that “the lending relationship under the Term Loan Agreement was centered in New York, governed by New York law, and allowed all of the parties, including [Immigon], to enjoy the benefits of the U.S. banking system and New York’s status as a financial capital.” Immigon selected Bank of New York Mellon for its correspondent bank account and JP Morgan made the disputed payment to Immigon’s New York bank account. The Court found these contacts, among others, sufficient to show that Immigon had purposefully availed itself of the privilege of doing business in New York.

Finally, the Court found that subjecting Immigon to personal jurisdiction on any of these three grounds would not offend due process because the Court has a strong interest in adjudicating claims that arise under the Bankruptcy Code and the Trust has a strong interest in obtaining convenient and effective relief in the Bankruptcy Court. Moreover, the Court found that Immigon’s burden in having to litigate in New York is mitigated by the convenience of modern communication and transportation.

Practical Implications

The outcome of this case suggests the need for parties to carefully review proposed Bankruptcy Court orders affecting their rights. Here, in finding that Immigon had knowingly consented to the Bankruptcy Court’s jurisdiction in the DIP order, the Bankruptcy Court relied on evidence showing that an employee of Immigon had received and viewed the DIP order, despite the fact that the consent to jurisdiction provision was on page 26 of the 30-page order. The case also suggests the need for caution by parties purchasing interests in transactions governed by agreements with consent to jurisdiction clauses.

[1]. Immigon, or Immigon Portfolioabbau AG, is a wind-down company operating under Austrian law, and is the successor in interest to OEVAG, or Osterreichische Volksbanken Aktiengesellschaft, which was the central institute of the Austrian co-operative of banks named Volksbanken.

The Southern District of New York Bankruptcy Court recently limited certain bankruptcy discovery requests pursuant to Federal Rule of Bankruptcy Procedure 2004 by applying the concept of proportionality contained in the 2015 amendments to Federal Rule of Civil Procedure 26 . In re SunEdison, Inc., Case No. 16-10992 (SMB), ECF No. 2280 (Jan. 18, 2017). The court’s decision curtails the ability of non-debtors to conduct so-called “fishing expeditions,” which have become increasingly costly with the spread of requests for electronically stored information (often referred to as “ESI”). The court’s decision will be of particular interest to debtors’ counsel and assist in their efforts to stave off disruptive, costly and distracting Rule 2004 requests.

In re SunEdision arises from the application of CSI Leasing, Inc. and CSI Leasing Malaysia Sdn. Bhd. (collectively, “CSI”) to conduct a Rule 2004 examination of the debtors. CSI was a creditor of both the debtor-subsidiary SunEdison Products Singapore Pte. Ltd. (“SEPS”) and the non-debtor subsidiary SunEdison Kuching Sdn. Bhd. (“SEK”) in connection with a failed equipment lease, entered into by SEK and guaranteed by SEPS. As a result of SEK’s default on the lease and SEPS’s default on the guarantee, CSI had a claim against each for approximately $2.5 million. Notwithstanding the $2.5 million owed to CSI, when SEK received approximately $45 million for the sale of substantially all of its assets in March 2016, SEK transferred the money to the debtors, namely SunEdison, Inc. (“SUNE”), which is the ultimate parent company of both SEK and SEPS.

As part of its overall efforts to collect on its guarantee, CSI filed an application seeking Rule 2004 discovery in the chapter 11 proceedings. CSI requested, among other things, “all documents and communications” generally related to: (i) the transfer of the asset sale proceeds to the debtors; (ii) the debtors’ chapter 11 cases; and (iii) SEK, the Malaysian proceeding, and CSI’s recovery in that proceeding. After initially providing over 1,200 pages of responsive information on a rolling basis, the debtors subsequently objected to CSI’s application and argued that discovery was unnecessary as to CSI’s chapter 11 claims, which had been allowed. Beyond that, the debtors characterized CSI’s application as “premature, overly broad, speculative and unduly burdensome”.[1]

The court began by outlining the law governing Rule 2004 applications, noting that generally a party seeking Rule 2004 examination must demonstrate “good cause” for the examination. “Good cause,” in turn, is typically demonstrated by showing that the “proposed examination ‘is necessary to establish the claim of the party seeking the examination, or … denial of such request would cause the examiner undue hardship or injustice.’”[2]

However, the court noted that Rule 2004 examinations require a balance between the needs of the examiner and the burden imposed on the examinee.[3] This balance is especially necessary when juxtaposed with the immense costs of modern discovery on the producing party. If left unchecked, the court was concerned that a “fishing expedition” could impose astronomical discovery costs on the party being examined.

In weighing this balance between the examiner’s need for discovery and the burden imposed on the examinee, the court found a solution in the Federal Rules of Civil Procedure’s proportionality requirements under Rule 26.[4] Despite the absence of a comparable amendment to Rule 2004, the court drew a parallel between the aims of Rule 2004 and Rule 26.[5] The court used this parallel to support the holding that an when the applicant is seeking the examination in one proceeding for claims in another proceeding, as in this case, there was no good cause for such examination.[6]

The court’s opinion imposes an additional limitation on Rule 2004 examinations, which has often been recognized as allowing wider discovery than that available under the Federal Rules of Civil Procedure. Under Rule 2004, the subject matter open to discovery is broader, there are fewer procedural safeguards, and discovery can generally be wielded against any related entity. Bankruptcy courts have imposed few restraints on this rule, most of which prevent parties from taking advantage of such open-ended discovery when there is an on-going civil action between the same parties. However, by borrowing a constraint on Rule 2004 from the Federal Rules of Civil Procedure, the court has checked what is often a burdensome discovery mechanism.

The First Circuit’s recent opinion on the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”, 48 U.S.C §§ 2101-2241) outlines initial guidelines for possible future actions against the Puerto Rican government as a result of the Commonwealth’s ongoing debt crisis. Peaje Investments LLC v. García–Padilla, 845 F.3d 505 (1st Cir. 2017). Congress enacted PROMESA in June 2016 to create, among other things, a temporary stay of debt-related litigation against the government of Puerto Rico. The temporary stay was set to expire automatically on February 17, 2017, but has been extended until May 1, 2017. The First Circuit permitted one creditor to move immediately for relief from the stay, but blocked another creditor’s bid. The decision serves as a template for how creditors may move against the Commonwealth when the PROMESA stay expires later this spring.

In Peaje Investments LLC v. Garcia-Padilla, the First Circuit considered the appeal of two creditors whose motions for relief from PROMESA’s stay had been denied by the District Court of Puerto Rico without a hearing. The denied creditor, Peaje Investments LLC (“Peaje”), argued that the stay should be lifted so it could challenge the government’s diversion of toll revenues. The successful creditors, the Altair movants, similarly sought relief based on their interest in certain employee contributions diverted by the Commonwealth. The First Circuit applied the Bankruptcy Code’s “lack of adequate protection” standard to determine cause for lifting the stay.

In Peaje’s case, the creditor alleged that a bond resolution required the government to deposit toll revenues with a fiscal agent to serve as collateral for bonds issued by the Puerto Rico Highways and Transportation Authority. The First Circuit affirmed the District Court’s denial of Peaje’s motion because “toll revenues are ‘constantly replenished,’” allowing Peaje’s security interest to continue as a “stable, recurring source of income that will eventually provide funds for the repayment” of the bonds.[1]

The Altair movants similarly alleged that the Commonwealth had suspended transfers of employee retirement contributions, which served as collateral for their bonds, to the required fiscal agent. The Altair movants, crucially, included in their filings a statement by the Commonwealth’s Employees Retirement System that “uncertainty about future employee contributions could affect” repayment of the bonds held by the Altair movants. The District Court characterized these contributions as “a perpetual revenue stream whose value is not decreased by the Commonwealth’s acts,” much like Peaje’s collateral, but the First Circuit reversed course. It found that the Altair movants deserved a hearing to demonstrate the “alleged uncertainty” of the Commonwealth’s ability to repay the bonds.[2]

The stay will expire in May, at which point an influx of actions against the government of Puerto Rico relating to the debt crisis is expected. The First Circuit’s decision is limited in scope due to the PROMESA stay’s anticipated expiration, but creditors pursuing litigation against the government after the stay is lifted may choose to heed the opinion’s underlying guidance: do not hold back in initial pleadings.

We are pleased to share with you the Hughes Hubbard Bankruptcy Review for 2016. Restructurings are often the ultimate “bet-the-company” case, and we thank our clients for their continuing trust and confidence in our team.

A recent decision in the Bankruptcy Court for the District of Delaware explored the limits of mandatory subordination under section 510(b) of the Bankruptcy Code. In In re FAH Liquidating Corp., No. 13-13087(KG), 2017 WL 95115 (Bankr. D. Del. Jan. 10, 2017), Judge Kevin Gross ruled that membership units in special purpose vehicles that held securities of a debtor were outside the scope of section 510(b) because they were neither “securit[ies] of the debtor” nor securities of “an affiliate of the debtor.” Because the claimants invested in special purpose vehicles that were insulated from the debtor, their securities law claims against the debtor were indirect and therefore not subject to mandatory subordination.

Prior to the Petition Date, the debtor’s predecessor, Fisker Automotive Holdings, Inc. (“Fisker”), issued preferred stock. Fisker engaged Advanced Equities, Inc. (“AEI”) to aid in raising private capital. As memorialized in a Placement Agreement, AEI would receive, among other things, warrants that it could transfer to other broker-dealers that it designated as sub-agents. One such sub-agent, Middlebury Securities LLC (“Middlebury Securities”), entered into a Sub-Placement Agreement with AEI. Middlebury Securities solicited qualified investors for purchase of Membership Units in one or more[1] Special Purpose Vehicles, affiliated with Middlebury Securities, that themselves purchased or held Fisker’s preferred shares. Notably, however, there was no direct contractual relationship between Fisker and Middlebury Securities; rather, each contracted separately with AEI.

Two sets of plaintiffs commenced securities lawsuits against controlling shareholders and current and former officers and directors of Fisker, and filed proofs of claim on account of securities law claims against Fisker. One set of plaintiffs had purchased Fisker’s preferred stock (the “Direct Purchasers”), while the other plaintiffs had purchased membership units in one or more of the Special Purpose Vehicles (the “Membership Unit Purchasers”).

The parties and the Bankruptcy Court agreed that the Direct Purchasers’ claims against Fisker were subject to mandatory subordination under section 510(b) of the Bankruptcy Code, which subordinates any “claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim.”[2]

The parties also agreed that the Membership Units were “securities” and that the plaintiffs’ claims arose from the purchase or sale of securities. However, the parties disputed the application of section 510(b) to the claims of the Membership Unit Purchasers.

Although the Membership Units did not represent direct interests in Fisker, the Liquidating Trustee argued that purchases of Fisker securities were “part of the causal link leading to” the alleged injuries, and thus the Membership Unit Purchasers’ claims arose from the purchase or sale of a debtor’s securities. The Liquidating Trustee further argued that there was a “complete identity of economic interest” between the Membership Units and Fisker’s securities.

In the alternative, the Liquidating Trustee argued that the Membership Unit Purchasers’ claims arose from the purchase or sale of securities of “an affiliate of the debtor” because Middlebury Securities acted as an intermediary between Fisker and investors for purposes of raising capital for Fisker. In the Liquidating Trustee’s view, the Special Purpose Vehicles were “affiliates” of Fisker because they were operated under the Placement Agreement between Fisker and AEI, pursuant to which AEI designated Middlebury Securities as its sub-agent.

The Bankruptcy Court first rejected the Liquidating Trustee’s argument that the Membership Units were securities “of the debtor.” The Bankruptcy Court noted that the Membership Units were distanced and insulated from Fisker due to the Special Purpose Vehicles: the Special Purpose Vehicles were not debtors, the Membership Units were not part of Fisker’s capital structure, and the Membership Unit Purchasers did not have actual ownership interests in Fisker.

The Bankruptcy Court next addressed the Liquidating Trustee’s contention that the Membership Units were the securities of Fisker’s affiliates. Section 101(2) of the Bankruptcy Code defines an “affiliate” as, among other things, a “person whose business is operated under a lease or operating agreement by a debtor, or [a] person substantially all of whose property is operated under an operating agreement with the debtor.”[3] Focusing on that definition, the Bankruptcy Court emphasized that there was no contract between Fisker and Middlebury Securities. The Placement Agreement was between Fisker and AEI; AEI separately contracted with Middlebury Securities as sub-agent to sell Membership Units. The Special Purpose Vehicles thus fell outside the scope of section 101(2)(C): they were not “operat[ing] under an operating agreement with the debtor” (emphasis added).

The Bankruptcy Court further noted that the Fifth Circuit has applied a more expansive view of section 101(2)(C) where a debtor is “in full control” of another entity. However, the Bankruptcy Court found that the Debtors did not exert sufficient control to make the Special Purpose Vehicle entities mere “shell conduit[s] between [the] debtor and [the] entity.” AEI acted as an independent contractor, and it used its own authority to contract with Middlebury Securities. In fact, Fisker’s agreement with AEI even prohibited Fisker from communicating directly with sub-agents (like Middlebury Securities) without AEI’s authority.

The Bankruptcy Court’s decision shows that even the broad terms of section 510(b) have limits. Where a special purpose entity is sufficiently insulated from the debtor whose securities it holds, an investor in the special purpose entity may be able to maintain unsubordinated claims against the debtor (or the debtors’ directors and officers). Purchasers of securities should be aware that claims against debtors on account of purchases of membership interests in unaffiliated special purpose vehicles may potentially be due a higher priority than claims on account of direct purchases of the debtor’s securities. For their part, debtors and trustees should be aware that they may not be able to rely on section 510(b) in defending against such claims.

[1]. The decision notes that only one Special Purpose Entity— Middlebury Ventures II— was identified by name on the record, although the term was used in the plural by the Plaintiffs. Id. at *5-6. Thus, it was “unclear from the record whether [Middlebury Ventures II] is the only Special Purpose Vehicle that issued the Membership Units.” Id. at *7.

Post navigation

About this Publication

Hughes Hubbard’s Corporate Reorganization & Bankruptcy group represents companies, creditors and trustees in complex restructurings—both in and out of court—and in the multiple types of litigation that insolvency proceedings generate.

About Hughes Hubbard

Hughes Hubbard & Reed LLP is an international law firm ranked for 12 years on The American Lawyer’s A-List of what the magazine calls “the top firms among the nation’s legal elite.” The firm was founded in 1888 by the renowned jurist and statesman Charles Evans Hughes.